Management Consulting/Managerial Economics
I am doing MBA General in Annamalai University. If you give me the answers for the below questions related to the subject of Managerial Economics it will be very greatful to you. Thanks in advance
Write short notes on:
(a) Profit Maximization?
(b) Social responsibilities of business.
(c) Types of Demand
(d) Variable cost.
(e) Monopoly market.
(f) Cost volume profit analysis.
(g) National Income.
(h) Penetration pricing.
(a) Profit Maximization?
The profit maximization principle stresses on the fact that the motive of business firms to maximize profit is solely justified as being a method of maximizing the income of their shareholders.
Firms may maximize profit by maximizing sales, stock price, market share or cash flow. In order to achieve maximum profit the firm needs to find out the point where the difference between total revenue and total cost is the highest.
The rules that apply for profit maximization are:
i. increase output as long as marginal profit increases
ii. profit will increase as long as marginal revenue (MR) > marginal cost (MC)
iii. profit will decline if MR < MC
iv. summing up (ii) and (iii), profit is maximized when MR = MC
A process that companies undergo to determine the best output and price levels in order to maximize its return . The company will usually adjust influential factors such as production costs , sales prices, and output levels as a way of reaching its profit goal . There are two main profit maximization methods used, and they are marginal Cost-Marginal revenue method and Total Cost-Total Revenue Method. Profit maximization is a good thing for a company, but can be a bad thing for consumers if the company starts to use cheaper products or decides to raise prices.
(b) Economic theory is based on the reasonable notion that people attempt to do as well as they can for themselves, given the constraints facing them. For example, consumers purchase things that they believe will make them feel more satisfied, but their purchases are limited (at least in the long run) by the amount of income they earn. A consumer can borrow to finance current purchases but must (if honest) repay the loans at a later date.
(c) Business owners also attempt to manage their businesses so as to improve their well being. Since the real world is a complicated place, a business owner may improve his well being in a number of ways. For example, if the business doesn't lack customers, the owner could respond by reducing operating hours and enjoying more leisure. Or, the business owner may seek satisfaction by earning as much profit as possible. This is the alternative we will focus on in class - for a very good reason. If a business faces tough competition, the only way the business can survive is to pay attention to revenues and costs. In many industries, profit maximization is not simply a potential goal; it's the only feasible goal, given the desire of other businesspeople to drive their competitors out of business.
(d) In economic terms, profit is the difference between a firm's total revenue and its total opportunity cost. Total revenue is the amount of income earned by selling products. In our simplified examples, total revenue equals P x Q, the (single) price of the product multiplied times the number of units sold. Total opportunity cost includes both the costs of all inputs into the production process plus the value of the highest-valued alternatives to which owned resources could be put. For example, a firm that has $100,000 in cash could invest in new, more efficient, machines to reduce its unit production costs. But the firm could just as well use the $100,000 to purchase bonds paying a 7% rate of interest. If the firm uses the money to buy new machinery, it must recognize that it is giving up $7000 per year in forgone interest earnings. The $7000 represents the opportunity cost of using the funds to buy the machinery.
(e) We will assume that the overriding goal of the managers of firms is to maximize profit: = TR - TC. The managers do this by increasing total revenue (TR) or reducing total opportunity cost (TC) so that the difference rises to a maximum.
(f) An Example
(g) Suppose you are running a business that produces and sells office furniture. It's a small operation, and in a typical day you produce three custom desks. You are able sell these desks for $500 apiece. You employ five workers, each of whom earns $15 per hour ($120 per day), and you work alongside them and pay yourself at the same rate. Material inputs cost $150 per desk. Of course, you have additional "overhead" expenses, including rent, a secretary/bookkeeper, electricity, etc. This overhead, which we will assume does not vary with the number of desks produced (i.e., it's a fixed cost) comes to $130 per day. Thus, your company earns a profit of = ($500 x 3) - ($720 + 450 + 130) = $1500 - $1300 = $200 per day. (Wages for six workers come to $720. Materials for three desks cost $450. Overhead is $130.) Working five days a week for 50 weeks a year, that comes to an annual profit of $50,000. Pretty nice - but could you do better?
(h) Suppose you decide to increase production to four desks per day. This requires you to hire two more workers (at another $240) and purchase another $150 worth of materials. Overhead expense doesn't change. Your total cost rises to $1690. You find that you are able to sell the fourth desk for $500. Was this a good decision? [Engage brain here.]
(i) You're right. [I'm giving you the benefit of the doubt here.] Total revenue rises to $2000 per day, while total costs rise to $1690. Profit increases to $310 per day. Good show, old man/woman/[insert desired politically correct term here]!
(j) This nice result may lead you to increase production to five desks a day. If you are able to sell all five desks for $500 each, and if your variable costs of producing the desks - what you pay in labor and materials - doesn't increase, producing a fifth desk makes sense. TR rises to $2500, TC rises to $2080, and profit increases to $420. So you sell five desks.
(k) Suppose, however, that you find that the labor market is so tight that you cannot hire another two workers at $15 per hour. In fact, to hire your ninth and tenth workers, you must pay $20 per hour. That increases the labor cost of the fifth desk by $80 ($40 per worker times two workers). TC rises to $2160, which still allows profit to increase to $340. But we have a problem brewing. Can you really get away with paying your veteran workers $15 an hour, while at the same time hiring new workers at $20 per hour? Not likely. So when you hire the ninth and tenth workers, you are forced to raise the wages of your first eight workers (Pay yourself more; hey, you deserve it.). Let's recalculate profit for Q = 5. TR = $500 x 5 = $2500. TC = ($160 x 10) + ($150 x 5) + $130 = $2480. That leaves a profit of $20. Doesn't look like such a good idea now, does it Einstein? Thus, if you realize that your costs will rise sharply if you produce a fifth desk each day, you will decline to produce the desk.
(b) Social responsibilities of business.
Corporate Social Responsibility (CSR) is a concept whereby organizations consider the interests of society by taking responsibility for the impact of their activities on customers, suppliers, employees, shareholders, communities and the environment in all aspects of their operations. This obligation is seen to extend beyond the statutory obligation to comply with legislation and sees organizations voluntarily taking further steps to improve the quality of life for employees and their families as well as for the local community and society at large.
The practice of CSR is subject to much debate and criticism. Proponents argue that there is a strong business case for CSR, in that corporations benefit in multiple ways by operating with a perspective broader and longer than their own immediate, short-term profits. Critics argue that CSR distracts from the fundamental economic role of businesses, others argue that it is nothing more than superficial window-dressing, still others argue that it is an attempt to pre-empt the role of governments as a watchdog over powerful multinational corporations.
The scale and nature of the benefits of CSR for an organization can vary depending on the nature of the enterprise, and are difficult to quantify, though there is a large body of literature exhorting business to adopt measures beyond financial ones , found a correlation between social/environmental performance and financial performance. However, businesses may not be looking at short-run financial returns when developing their CSR strategy.
The definition of CSR used within an organisation can vary from the strict "stakeholder impacts" definition used by many CSR advocates and will often include charitable efforts and volunteering. CSR may be based within the human resources, business development or public relations departments of an organisation, or may be given a separate unit reporting to the CEO or in some cases directly to the board. Some companies may implement CSR-type values without a clearly defined team or programme.
The business case for CSR within a company will likely rest on one or more of these arguments:
A CSR programme can be seen as an aid to recruitment and retention, particularly within the competitive graduate student market. Potential recruits often ask about a firm's CSR policy during an interview, and having a comprehensive policy can give an advantage. CSR can also help to improve the perception of a company among its staff, particularly when staff can become involved through payroll giving, fundraising activities or community volunteering.
Managing risk is a central part of many corporate strategies. Reputations that take decades to build up can be ruined in hours through incidents such as corruption scandals or environmental accidents. These events can also draw unwanted attention from regulators, courts, governments and media. Building a genuine culture of 'doing the right thing' within a corporation can offset these risks.
In crowded marketplaces, companies strive for a unique selling proposition which can separate them from the competition in the minds of consumers. CSR can play a role in building customer loyalty based on distinctive ethical values. Several major brands, such as The Co-operative Group and The Body Shop are built on ethical values. Business service organisations can benefit too from building a reputation for integrity and best practice.
License to operate
Corporations are keen to avoid interference in their business through taxation or regulations. By taking substantive voluntary steps, they can persuade governments and the wider public that they are taking issues such as health and safety, diversity or the environment seriously, and so avoid intervention. This also applies to firms seeking to justify eye-catching profits and high levels of boardroom pay. Those operating away from their home country can make sure they stay welcome by being good corporate citizens with respect to labour standards and impacts on the environment.
CSR is entwined in the strategic planning process of many multinational organizations. The reasons or drive behind social responsibility towards human and environmental responsibility whether driven by ulterior motives, enlightened self-interest, or interests beyond the enterprise, is subject to much debate and criticism.
Some critics argue that corporations are fundamentally entities responsible for generating a product and/or service to gain profits to satisfy shareholders.and others argue that there is no place for social responsibility as a business function.These critics point to the rule of corporate law that prohibits a corporation's directors from any activity that would reduce profits.
Other critics argue that the practice cherry-picks the good activities a company is involved with and ignores the others, thus 'greenwashing' their image as a socially or environmentally responsible company. Still other critics argue that it inhibits free markets or seeks to pre-empt the role of governments in controlling the socially or environmentally damaging effects of corporations' pursuit of self-interest.
philanthropy centric view of Corporate Social Responsibility (CSR
AS PART OF THEIR CONTRIBUTION TO THE SOCIETY,
SOME ORGANIZATIONS HAVE BEEN PRACTISING SUCH PROGRAMS AS
-better pay for local workers in the under-developed countries.
-avoiding under-age employees.
-support for local community sports.
-offer of free sports gears for talents.
-sports events sponsorship.
-supporting the construction of sports grounds.
-cheaper brands for selected countries
-local water supply
-community developments like sports etc
-local school sports support
-scholarships for talents
(c) Types of Demand
Demand:The term 'demand' is defined as the desire for a commodity which is backed by willingness to buy and ability to pay for it.
The different types of demands have been explained below as follows:
• Individual demand:
It is the quantity of a commodity demanded by an individual consumer at a particular price during a given period of time.
• Market demand:
It is the total quantity of a commodity demanded by all the consumers in the market during a given period of time.
• Joint demand:
When two or more commodities are jointly needed to satisfy a single want, then the demand for such goods are said to be joint demand.
• Composite demand:
When a commodity is demanded for a number of uses, then the demand for that commodity is said to composite in nature.
• Competitive demand:
When two goods are close substitutes of one another, then the demand for such goods is said to be competitive in nature.
• Derived demand:
When demand for a commodity gives rise to demand for another commodity, then it is said to be as a derived demand.
• Variation in demand:
It refers to extension or contraction in demand which is exclusively due to change in the price of a product.
• Changes in demand:
Change in demand refers to increase or decrease in demand which is due to change factors other than price of the commodity.
• Giffen goods:
It refers to some inferior goods which are demanded in smaller quantities when their price falls.
• Direct demand:
Goods which yield direct satisfaction to a customer can be termed as the direct demand.
• The different types of demand are;
• i) Direct and Derived Demands
• Direct demand refers to demand for goods meant for final consumption; it is the demand for consumers’ goods like food items, readymade garments and houses. By contrast, derived demand refers to demand for goods which are needed for further production; it is the demand for producers’ goods like industrial raw materials, machine tools and equipments.
• Thus the demand for an input or what is called a factor of production is a derived demand; its demand depends on the demand for output where the input enters. In fact, the quantity of demand for the final output as well as the degree of substituability/complementarty between inputs would determine the derived demand for a given input.
• For example, the demand for gas in a fertilizer plant depends on the amount of fertilizer to be produced and substitutability between gas and coal as the basis for fertilizer production. However, the direct demand for a product is not contingent upon the demand for other products.
• ii) Domestic and Industrial Demands
• The example of the refrigerator can be restated to distinguish between the demand for domestic consumption and the demand for industrial use. In case of certain industrial raw materials which are also used for domestic purpose, this distinction is very meaningful.
• For example, coal has both domestic and industrial demand, and the distinction is important from the standpoint of pricing and distribution of coal.
• iii) Autonomous and Induced Demand
• When the demand for a product is tied to the purchase of some parent product, its demand is called induced or derived.
• For example, the demand for cement is induced by (derived from) the demand for housing. As stated above, the demand for all producers’ goods is derived or induced. In addition, even in the realm of consumers’ goods, we may think of induced demand. Consider the complementary items like tea and sugar, bread and butter etc. The demand for butter (sugar) may be induced by the purchase of bread (tea). Autonomous demand, on the other hand, is not derived or induced. Unless a product is totally independent of the use of other products, it is difficult to talk about autonomous demand. In the present world of dependence, there is hardly any autonomous demand. Nobody today consumers just a single commodity; everybody consumes a bundle of commodities. Even then, all direct demand may be loosely called autonomous.
• iv) Perishable and Durable Goods’ Demands
• Both consumers’ goods and producers’ goods are further classified into perishable/non-durable/single-use goods and durable/non-perishable/repeated-use goods. The former refers to final output like bread or raw material like cement which can be used only once. The latter refers to items like shirt, car or a machine which can be used repeatedly. In other words, we can classify goods into several categories: single-use consumer goods, single-use producer goods, durable-use consumer goods and durable-use producer’s goods. This distinction is useful because durable products present more complicated problems of demand analysis than perishable products. Non-durable items are meant for meeting immediate (current) demand, but durable items are designed to meet current as well as future demand as they are used over a period of time. So, when durable items are purchased, they are considered to be an addition to stock of assets or wealth. Because of continuous use, such assets like furniture or washing machine, suffer depreciation and thus call for replacement. Thus durable goods demand has two varieties – replacement of old products and expansion of total stock. Such demands fluctuate with business conditions, speculation and price expectations. Real wealth effect influences demand for consumer durables.
• v) New and Replacement Demands
• This distinction follows readily from the previous one. If the purchase or acquisition of an item is meant as an addition to stock, it is a new demand. If the purchase of an item is meant for maintaining the old stock of capital/asset, it is replacement demand. Such replacement expenditure is to overcome depreciation in the existing stock.
• Producers’ goods like machines. The demand for spare parts of a machine is replacement demand, but the demand for the latest model of a particular machine (say, the latest generation computer) is anew demand. In course of preventive maintenance and breakdown maintenance, the engineer and his crew often express their replacement demand, but when a new process or a new technique or anew product is to be introduced, there is always a new demand.
• You may now argue that replacement demand is induced by the quantity and quality of the existing stock, whereas the new demand is of an autonomous type. However, such a distinction is more of degree than of kind. For example, when demonstration effect operates, a new demand may also be an induced demand. You may buy a new VCR, because your neighbor has recently bought one. Yours is a new purchase, yet it is induced by your neighbor’s demonstration.
• vi) Final and Intermediate Demands
• This distinction is again based on the type of goods- final or intermediate. The demand for semi-finished products, industrial raw materials and similar intermediate goods are all derived demands, i.e., induced by the demand for final goods. In the context of input-output models, such distinction is often employed.
• vii) Individual and Market Demands
• This distinction is often employed by the economist to study the size of the buyers’ demand, individual as well as collective. A market is visited by different consumers, consumer differences depending on factors like income, age, sex etc. They all react differently to the prevailing market price of a commodity. For example, when the price is very high, a low-income buyer may not buy anything, though a high income buyer may buy something. In such a case, we may distinguish between the demand of an individual buyer and that of the market which is the market which is the aggregate of individuals. You may note that both individual and market demand schedules (and hence curves, when plotted) obey the law of demand. But the purchasing capacity varies between individuals. For example, A is a high income consumer, B is a middle-income consumer and C is in the low-income group. This information is useful for personalized service or target-group-planning as a part of sales strategy formulation.
• viii) Total Market and Segmented Market Demands
• This distinction is made mostly on the same lines as above. Different individual buyers together may represent a given market segment; and several market segments together may represent the total market. For example, the Hindustan Machine Tools may compute the demand for its watches in the home and foreign markets separately; and then aggregate them together to estimate the total market demand for its HMT watches. This distinction takes care of different patterns of buying behavior and consumers’ preferences in different segments of the market. Such market segments may be defined in terms of criteria like location, age, sex, income, nationality, and so on
• x) Company and Industry Demands
• An industry is the aggregate of firms (companies). Thus the Company’s demand is similar to an individual demand, whereas the industry’s demand is similar to aggregated total demand. You may examine this distinction from the standpoint of both output and input.
• For example, you may think of the demand for cement produced by the Cement Corporation of India (i.e., a company’s demand), or the demand for cement produced by all cement manufacturing units including the CCI (i.e., an industry’s demand). Similarly, there may be demand for engineers by a single firm or demand for engineers by the industry as a whole, which is an example of demand for an input. You can appreciate that the determinants of a company’s demand may not always be the same as those of an industry’s. The inter-firm differences with regard to technology, product quality, financial position, market (demand) share, market leadership and competitiveness- all these are possible explanatory factors. In fact, a clear understanding of the relation between company and industry demands necessitates an understanding of different market structures.
Marketing management has the task of influenc¬ing the level, timings and composition of demand in a way that will help the organization to achieve its objectives. Also, A marketer has to take into consideration different types of demand for his product before he comes up with a strategy.
1 ] Negative Demand
The market is in a state of negative demand if; a major part of the market dislikes the product and may even pay a price to avoid it.
Eg: People have a negative demand for
• Dental work
• Gall bladder operation Employers feel a negative demand for
The marketing task is to analyse, why the market dislikes the products?
2] No Demands
Target consumers may be uninterested in the product. Ex – People have no demand for
• Farmers may not be interested in new farming methods
• College students may not be interested in a foreign language course.
The marketing task is to find ways to connect the benefits of the products to the person’s natural needs and interests.
3] Latent Demand:
Many consumers may share a strong need that cannot be satisfied by any existing products.
• Latent demand for harmless cigarettes.
• Safer neighborhood.
• More fuel efficient cars.
The marketing task is to measure the size of the potential market and develop effective goods and services that would satisfy the demand.
4] Declining Demand
A substantial drop in the demand for products.
• Boy scout enrolment among Singapore students.
The marketing task is to:
1. Analyse the cause of market decline.
2. Determine whether the demand can be re-stimulated by changing target markets, changing product features and developing more effective goods.
3. To reverse the declining demand through creative remarketing of the product.
5] Irregular Demand
Organizations face demand that varies on a seasonal, daily or even hourly basis, causing problems of idle capacity or overcrowded capacity.
• Markets :- visited on weekends, not on weekdays.
• Hospitals :- OT’s booked for early weak
The marketing task is called Synchro Marketing (alter pricing, promotion & other incentives)
6] Full Demand
Organizations face full demand when they are pleased with there volume of business.
The marketing task is to:
1. Maintain the current level of demand in the face of changing consumer preferences and increasing competition.
2. Quality should be improved.
3. Continuously measure consumer satisfaction.
Eg: Maruti at the time of bookings made open.
7] Overfull Demands
Some organizations face a demand level that is higher then they can or want to handle. Marketing task is De-marketing which requires finding ways to reduce the demand temporarily or permanently.
Steps involved in de-marketing:
1. Raising prices.
2. Reducing promotion and service.
3. Selective de-marketing(less profitable markets)
Eg: Quota system for new car registration by a fixed percentage annually.
8] Unwholesome Demand
Unwholesome products will attract organized effort to discourage their consumption. Un-selling campaigns have been conducted against cigarettes, alcohols, hard drugs, handguns and pirated movies.
(d) Variable cost.
A corporate expense that varies with production output. Variable costs are those costs that vary depending on a company's production volume; they rise as production increases and fall as production decreases. Variable costs differ from fixed costs such as rent, advertising, insurance and office supplies, which tend to remain the same regardless of production output. Fixed costs and variable costs comprise total cost.
Variable costs can include direct material costs or direct labor costs necessary to complete a certain project. For example, a company may have variable costs associated with the packaging of one of its products. As the company moves more of this product, the costs for packaging will increase. Conversely, when fewer of these products are sold the costs for packaging will consequently decrease.
FIRST, IDENTIFY THE
Elements of cost
• 1. Material(Material is a very important part of business)
• A. Direct material
• B. Indirect material
• 2. Labour
• A. Direct labor
• B. Indirect labor
• 3. Overhead
• A. Indirect material
• B. Indirect labor
• They are grouped further based on their functions as,
• 1. Production or works overheads
• 2. Administration overheads
• 3. Selling overheads
• 4. Distribution overheads
Classification of costs
Classification of cost means, the grouping of costs according to their common characteristics. The important ways of classification of costs are:
• By nature or element: materials, labor, expenses
• By functions: production, selling, distribution, administration, R&D, development,
• As direct and indirect
• By variability: fixed, variable, semi-variable
• By controllability: controllable, uncontrollable
• By normality: normal, abnormal
WHAT TYPES OF ACCOUNTING IS USED
Standard cost accounting
In modern cost accounting, the concept of recording historical costs was taken further, by allocating the company's fixed costs over a given period of time to the items produced during that period, and recording the result as the total cost of production. This allowed the full cost of products that were not sold in the period they were produced to be recorded in inventory using a variety of complex accounting methods, which was consistent with the principles of GAAP (Generally Accepted Accounting Principles). It also essentially enabled managers to ignore the fixed costs, and look at the results of each period in relation to the "standard cost" for any given product.
For example: if the railway coach company normally produced 40 coaches per month, and the fixed costs were still $1000/month, then each coach could be said to incur an overhead of $25 ($1000 / 40). Adding this to the variable costs of $300 per coach produced a full cost of $325 per coach.
This method tended to slightly distort the resulting unit cost, but in mass-production industries that made one product line, and where the fixed costs were relatively low, the distortion was very minor.
For example: if the railway coach company made 100 coaches one month, then the unit cost would become $310 per coach ($300 + ($1000 / 100)). If the next month the company made 50 coaches, then the unit cost = $320 per coach ($300 + ($1000 / 50)), a relatively minor difference.
An important part of standard cost accounting is a variance analysis which breaks down the variation between actual cost and standard costs into various components (volume variation, material cost variation, labor cost variation, etc.) so managers can understand why costs were different from what was planned and take appropriate action to correct the situation.
ACTIVITY -BASED COSTING (ABC) is a system for assigning costs to products based on the activities they require. In this case, activities are those regular actions performed inside a company. "Talking with customer regarding invoice questions" is an example of an activity inside most companies.
Accountants assign 100% of each employee's time to the different activities performed inside a company (many will use surveys to have the workers themselves assign their time to the different activities). The accountant then can determine the total cost spent on each activity by summing up the percentage of each worker's salary spent on that activity.
A company can use the resulting activity cost data to determine where to focus their operational improvements. For example, a job-based manufacturer may find that a high percentage of its workers are spending their time trying to figure out a hastily written customer order. Via ABC, the accountants now have a currency amount pegged to the activity of "Researching Customer Work Order Specifications". Senior management can now decide how much focus or money to budget for resolving this process deficiency. ACTIVITY BASED MANAGEMENT includes (but is not restricted to) the use of activity-based costing to manage a business.
While ABC may be able to pinpoint the cost of each activity and resources into the ultimate product, the process could be tedious, costly and subject to errors.
As it is a tool for a more accurate way of allocating fixed costs into product, these fixed costs do not vary according to each month's production volume. For example, an elimination of one product would not eliminate the overhead or even direct labor cost assigned to it. ABC better identifies product costing in the long run, but may not be too helpful in day-to-day decision-making.
LEAN ACCOUNTING provides the accounting, control, and measurement methods supporting lean manufacturing and other applications of lean thinking such as healthcare, construction, insurance, banking, education, government, and other industries.
There are two main thrusts for Lean Accounting. The first is the application of lean methods to the company's accounting, control, and measurement processes. This is no different than applying lean methods to any other processes. The objective is to eliminate waste, free up capacity, speed up the process, eliminate errors & defects, and make the process clear and understandable.
The second (and more important) thrust of Lean Accounting is to fundamentally change the accounting, control, and measurement processes so they motivate lean change & improvement, provide information that is suitable for control and decision-making, provide an understanding of customer value, correctly assess the financial impact of lean improvement, and are themselves simple, visual, and low-waste. Lean Accounting does not require the traditional management accounting methods like standard costing, activity-based costing, variance reporting, cost-plus pricing, complex transactional control systems, and untimely & confusing financial reports. These are replaced by:
• lean-focused performance measurements
• simple summary direct costing of the value streams
• decision-making and reporting using a box score
• financial reports that are timely and presented in "plain English" that everyone can understand
• radical simplification and elimination of transactional control systems by eliminating the need for them
• driving lean changes from a deep understanding of the value created for the customers
• eliminating traditional budgeting through monthly sales, operations, and financial planning processes (SOFP)
• value-based pricing
• correct understanding of the financial impact of lean change
As an organization becomes more mature with lean thinking and methods, they recognize that the combined methods of lean accounting in fact creates a lean management system (LMS) designed to provide the planning, the operational and financial reporting, and the motivation for change required to prosper the company's on-going lean transformation.
This method is used particularly for short-term decision-making. Its principal tenets are:
• Revenue (per product) - variable costs (per product) = contribution (per product)
• Total contribution - total fixed costs = total profit or total loss)
Thus, it does not attempt to allocate fixed costs in an arbitrary manner to different products. The short-term objective is to maximize contribution per unit. If constraints exist on resources, then Managerial Accounting dictates that marginal cost analysis be employed to maximize contribution per unit of the constrained resource .
Types of Allocations
Cost allocations can be made both within and across time periods. If two or more cost objects share a common facility or program, the cost pool of the shared unit is a common cost to the users and must be divided or allocated to them. Bases of allocation typically are based on one of the following criteria: cause-and-effect, benefits derived, fairness, or ability to bear. The selection of a criterion can affect the selection of a basis. For example, the allocation of the costs of a common service activity across product lines or programs based on relative amounts of revenue is an ability to bear basis, whereas the same allocation based on the relative number of service units consumed by each product line or program would reflect either the benefits derived or the cause-and-effect criteria. Cost allocation then is the assignment of an indirect cost to one or more cost objects according to some formula. Because this process is not a direct assignment and results in different amounts allocated depending on either the basis of allocation or the method (formula) selected, some consider cost allocation to be of an arbitrary nature, to some extent.
Costs of long-lived assets are allocated and reclassified as an expense across two or more time periods. For anything other than land, which is not allocated, the reclassification of tangible assets is called depreciation (for anything other than natural resources) or depletion (for natural resources) expense. The bases for these allocations are normally either time or volume of activity. Different methods of depreciation and depletion are available. The costs of long-lived intangible assets, such as patents, are allocated across time periods and reclassified as amortization expense. The basis for these allocations is normally time.
Cost allocations within a time period are typically across either organizational segments known as responsibility centers or across units of product or service or programs for which a full cost is needed. Allocations may differ depending on whether a product or program is being costed for financial reporting, government contract reimbursement , reporting to governmental agencies, target pricing or costing, or life-cycle profitability analysis. Allocations to responsibility centers are made to motivate the centers' managers to be more goal-congruent in their decisions and to assign to each center an amount of cost reflective of all the sacrifices made by the overall organization on behalf of the center. These allocations can be part of a price or transfers of cost pools from one department to another.
(e) Monopoly market.
A type of market that features one, if not all, of the traits of a monopoly such as high price levels, supply constraints, or excessive barriers to entry. Because this type of market would be comprised of one supplying firm, consumers would have no choice but to purchase solely from this firm. Without proper legislation or controls, this firm possesses the power to raise prices without adversely affecting demand for its products/services. This type of market stands in contrast to a perfectly competitive market.
A monopolistic market favors companies to the detriment of consumers. The market, in this case, is usually defined as a stock market sector such as telecommunications or media firms, where this type of market behavior is likely to be found.
There are several groups and trade organizations, such as the FCC, WTO and EU governing council, that ensure that monopolistic markets do not form and also create legal ramifications for companies that pursue market-cornering policies. The Microsoft antitrust trials of the late '90s show that the markets are still fighting against monopolistic behavior, even today.
Characteristics / Features of Monopoly
Following are the features or characteristics of Monopoly :-
1. A single seller has complete control over the supply of the commodity.
2. There are no close substitutes for the product.
3. There is no free entry and exit because of some restrictions.
4. There is a complete negation of competition.
5. Monopolist is a price maker.
6. Since there is a single firm, the firm and industry are one and same i.e. firm coincides the industry.
7. Monopoly firm faces downward sloping demand curve. It means he can sell more at lower price and vice versa. Therefore, elasticity of demand factor is very important for him.
Classification / Kinds / Types of Monopoly
1. Perfect Monopoly
It is also called as absolute monopoly. In this case, there is only a single seller of product having no close substitute; not even remote one. There is absolutely zero level of competition. Such monopoly is practically very rare.
2. Imperfect Monopoly
It is also called as relative monopoly or simple or limited monopoly. It refers to a single seller market having no close substitute. It means in this market, a product may have a remote substitute. So, there is fear of competition to some extent e.g. Mobile (Cellphone) telcom industry (e.g. vodaphone) is having competition from fixed landline phone service industry (e.g. BSNL).
3. Private Monopoly
When production is owned, controlled and managed by the individual, or private body or private organization, it is called private monopoly. e.g. Tata, Reliance, Bajaj, etc. groups in India. Such type of monopoly is profit oriented.
4. Public Monopoly
When production is owned, controlled and managed by government, it is called public monopoly. It is welfare and service oriented. So, it is also called as 'Welfare Monopoly' e.g. Railways, Defence, etc.
5. Simple Monopoly
Simple monopoly firm charges a uniform price or single price to all the customers. He operates in a single market.
6. Discriminating Monopoly
Such a monopoly firm charges different price to different customers for the same product. It prevails in more than one market.
7. Legal Monopoly
When monopoly exists on account of trade marks, patents, copy rights, statutory regulation of government etc., it is called legal monopoly. Music industry is an example of legal monopoly.
8. Natural Monopoly
It emerges as a result of natural advantages like good location, abundant mineral resources, etc. e.g. Gulf countries are having monopoly in crude oil exploration activities because of plenty of natural oil resources.
9. Technological Monopoly
It emerges as a result of economies of large scale production, use of capital goods, new production methods, etc. E.g. engineering goods industry, automobile industry, software industry, etc.
10. Joint Monopoly
A number of business firms acquire monopoly position through amalgamation, cartels, syndicates, etc, it becomes joint monopoly. e.g. Actually, pizza making firm and burger making firm are competitors of each other in fast food industry. But when they combine their business, that leads to reduction in competition. So they can enjoy monopoly power in market.
(f) Cost volume profit analysis.
A method of cost accounting used in managerial economics. Cost-volume profit analysis is based upon determining the breakeven point of cost and volume of goods. It can be useful for managers making short-term economic decisions, and also for general educational purposes.
Cost-volume profit analysis makes several assumptions in order to be relevant. It often assumes that the sales price, fixed costs and variable cost per unit are constant. Running this analysis involves using several equations using price, cost and other variables and plotting them out on an economic graph.
Cost-volume-profit (CVP) analysis is used to determine how changes in costs and volume affect a company's operating income and net income. In performing this analysis, there are several assumptions made, including:
• Sales price per unit is constant.
• Variable costs per unit are constant.
• Total fixed costs are constant.
• Everything produced is sold.
• Costs are only affected because activity changes.
• If a company sells more than one product, they are sold in the same mix.
CVP analysis requires that all the company's costs, including manufacturing, selling, and administrative costs, be identified as variable or fixed.
Contribution margin and contribution margin ratio
Key calculations when using CVP analysis are the contribution margin and the contribution margin ratio. The contribution margin represents the amount of income or profit the company made before deducting its fixed costs. Said another way, it is the amount of sales dollars available to cover (or contribute to) fixed costs. When calculated as a ratio, it is the percent of sales dollars available to cover fixed costs. Once fixed costs are covered, the next dollar of sales results in the company having income.
The contribution margin is sales revenue minus all variable costs. It may be calculated using dollars or on a per unit basis. If The Three M's, Inc., has sales of $750,000 and total variable costs of $450,000, its contribution margin is $300,000. Assuming the company sold 250,000 units during the year, the per unit sales price is $3 and the total variable cost per unit is $1.80. The contribution margin per unit is $1.20. The contribution margin ratio is 40%. It can be calculated using either the contribution margin in dollars or the contribution margin per unit. To calculate the contribution margin ratio, the contribution margin is divided by the sales or revenues amount.
The break-even point represents the level of sales where net income equals zero. In other words, the point where sales revenue equals total variable costs plus total fixed costs, and contribution margin equals fixed costs. Using the previous information and given that the company has fixed costs of $300,000, the break-even income statement shows zero net income.
The Three M's, Inc. Break-Even Income Statement
Revenues (250,000 units × $3) $750,000
Variable Costs (250,000 units × $1.80) 450,000
Contribution Margin 300,000
Fixed Costs 300,000
Net Income $ 0
This income statement format is known as the contribution margin income statement and is used for internal reporting only.
The $1.80 per unit or $450,000 of variable costs represent all variable costs including costs classified as manufacturing costs, selling expenses, and administrative expenses. Similarly, the fixed costs represent total manufacturing, selling, and administrative fixed costs.
Break-even point in dollars. The break-even point in sales dollars of $750,000 is calculated by dividing total fixed costs of $300,000 by the contribution margin ratio of 40%.
Another way to calculate break-even sales dollars is to use the mathematical equation.
In this equation, the variable costs are stated as a percent of sales. If a unit has a $3.00 selling price and variable costs of $1.80, variable costs as a percent of sales is 60% ($1.80 ÷ $3.00). Using fixed costs of $300,000, the break-even equation is shown below.
The last calculation using the mathematical equation is the same as the break-even sales formula using the fixed costs and the contribution margin ratio previously discussed in this chapter.
Break-even point in units. The break-even point in units of 250,000 is calculated by dividing fixed costs of $300,000 by contribution margin per unit of $1.20.
The break-even point in units may also be calculated using the mathematical equation where “X” equals break-even units.
Again it should be noted that the last portion of the calculation using the mathematical equation is the same as the first calculation of break-even units that used the contribution margin per unit. Once the break-even point in units has been calculated, the break-even point in sales dollars may be calculated by multiplying the number of break-even units by the selling price per unit. This also works in reverse. If the break-even point in sales dollars is known, it can be divided by the selling price per unit to determine the break-even point in units.
CVP analysis is also used when a company is trying to determine what level of sales is necessary to reach a specific level of income, also called targeted income. To calculate the required sales level, the targeted income is added to fixed costs, and the total is divided by the contribution margin ratio to determine required sales dollars, or the total is divided by contribution margin per unit to determine the required sales level in units.
Using the data from the previous example, what level of sales would be required if the company wanted $60,000 of income? The $60,000 of income required is called the targeted income. The required sales level is $900,000 and the required number of units is 300,000. Why is the answer $900,000 instead of $810,000 ($750,000 [break-even sales] plus $60,000)? Remember that there are additional variable costs incurred every time an additional unit is sold, and these costs reduce the extra revenues when calculating income.
This calculation of targeted income assumes it is being calculated for a division as it ignores income taxes. If a targeted net income (income after taxes) is being calculated, then income taxes would also be added to fixed costs along with targeted net income.
Assuming the company has a 40% income tax rate, its break-even point in sales is $1,000,000 and break-even point in units is 333,333. The amount of income taxes used in the calculation is $40,000 ([$60,000 net income ÷ (1 – .40 tax rate)] – $60,000).
A summarized contribution margin income statement can be used to prove these calculations.
The Three M's, Inc. Income Statement 20X0 Targeted Net Income
Sales (333,333 * units × $3)
Variable Costs (333,333 * units × $1.80)
Contribution Margin 400,000
Fixed Costs 300,000
Income before Taxes 100,000
Income Taxes (40%) 40,000
Net Income $ 60,000
(g) National Income.
National income is the total value a country’s final output of all new goods and services produced in one year. Understanding how national income is created is the starting point for macroeconomics.
The national income identity
This relationship is expressed in the national income identity, where the amount received as national income is identical to the amount spent as national expenditure, which is also identical to what is produced as national output. Throughout macroeconomics the terms income, output and expenditure are interchangeable.
National income accounts
Since the 1940s, the UK government has gathered detailed records of national income, though the collection of basic data goes back to the 17th Century. The published national income accounts for the UK, called the ‘Blue Book’, measure all the economic activities that ‘add value’ to the economy.
National output, income and expenditure, are generated when there is an exchange involving a monetary transaction. However, for an individual economic transaction to be included in aggregate national income it must involve the purchase of newly produced goods or services. In other words, it must create a genuine addition to the ‘value’ of the scarce resources. For example, a transaction that involves selling a second-hand good, and which was new two years ago does not add to national income, though the original production and purchase does. Transactions which do not add value are called transfers, and include second-hand sales, gifts and welfare transfers paid by the government, such as disability allowance and state pensions.
The creation of national income
The simplest way to think about national income is to consider what happens when one product is manufactured and sold. Typically, goods are produced in a number of 'stages', where raw materials are converted by firms at one stage, then sold to firms at the next stage. Value is added at each, intermediate, stage, and, at the final stage, the product is given a retail selling price. The retail price reflects the value added in terms of all the resources used in all the previous stages of production.
In accounting terms, only the value of final output is recorded. To avoid the problem of double counting, only the value of the final stage, the retail price, is included, and not the value added in all the intermediate stages - the costs of production, plus profits. In short, national income is the value of all the final output of goods and services produced in one year.
For example, consider the production of a motor car which has a retail price of £25,000. This price includes £21,000 for all the costs of production (£6,000 for components, £10,000 for assembly and £5,000 for marketing) plus £4,000 for profit. To avoid double-counting, the national income accounts only record the value of the final stage, which in this case is the selling price of £25,000.
When goods are bought second-hand, the transaction does not add new value and will not be included in national output. If second-hand goods are included, double-counting will occur, and this would falsely inflate the value of national income.
For example, if the car in question is sold in two year’s time for £15,000 it would provide the owner with money, but the sale will not add to national income. If it were included in national income, it would make the value of the car £35,000 - the initial £25,000 plus the second hand value of £15,000. This is clearly not the case, so any future second-hand sales are not included when valuing national income. Such second-hand transactions are called transfers.
Calculating national income
Any transaction which adds value involves three elements – expenditure by purchasers, income received by sellers, and the value of the goods traded. For example, if a student purchases a textbook for £30, spending = £30, income to the bookseller = £30, and the value of the book = £30. All of the transactions in an economy can be looked at in this way, giving us three ways to measure national income.
There are three methods of calculating national income:
1. The income method, which adds up all incomes received by the factors of production generated in the economy during a year. This includes wages from employment and self-employment, profits to firms, interest to lenders of capital and rents to owners of land.
2. The output method, which is the combined value of the new and final output produced in all sectors of the economy, including manufacturing, financial services, transport, leisure and agriculture.
3. The expenditure method, which adds up all spending in the economy by households and firms on new and final goods and services by households and firms.
Chained value measurement
The components of national output are valued according to their importance to the overall economy. The weights used were based on estimates made every 5 years, but, from 2003, an annual adjustment to the weightings was introduced to improve the reliability of the weighting - a process called annual chain linking. This allowed for a more up-to-date, and therefore a more accurate measure of changes to the level of national income.
(h) Penetration pricing.
A marketing strategy used by firms to attract customers to a new product or service. Penetration pricing is the practice of offering a low price for a new product or service during its initial offering in order to attract cu tomers away from competitors. The reasoning behind this marketing strategy is that customers will buy and become aware of the new product due to its lower price in the marketplace relative to rivals.
Penetration pricing can be a successful marketing strategy when applied correctly. It can often increase both market share and sales volume. Additionally, the high sales volume can also lead to lower production costs and higher inventory turnover, both of which are positive for any firm with fixed overhead.
The chief disadvantage, however, is that the increase in sales volume may not necessarily lead to a profit if prices are kept too low. As well, if the price is only an introductory campaign, customers may leave the brand once prices begin to rise to levels more in line with rivals.
Penetration pricing pursues the objective of quantity maximization by means of a ,.v price. It is most appropriate when:
* Demand is expected to be highly elastic; that is, customers are price sensitive and the quantity demanded will increase significantly as price declines,
• Large decreases in cost are expected as cumulative volume increases,
• The product is of the nature of something that can gain mass appeal fairly quickly.’
•' There is a threat of impending competition.
'As the product lifecycle progresses, there likely will be changes in the demand
curve and costs. As such, the pricing policy should reevaluated over time.
THE PRICING OBJECTIVE DEPENDS ON MANY FACTORS INCLUDING
PRODUCTION COST,EXISTENCE OF ECONOMIES OF SCALE, BARRIERS TO ENTRY, PRODUCT DIFFERENTIATION , RATE OF PRODUCT DIFFUSION,
THE FIRM’S RESOURCES, AND THE PRODUCT’S ANTICIPATED PRICE ELASTICITY OF DEMAND.
Penetration pricing is most commonly associated with a marketing objective of increasing market share or sales volume. In the short term, penetration pricing is likely to result in lower profits than would be the case if price were set higher. However, there are some significant benefits to long-term profitability of having a higher market share, so the pricing strategy can often be justified.
Penetration pricing is often used to support the launch of a new product, and works best when a product enters a market with relatively little product differentiation and where demand is price elastic – so a lower price than rival products is a competitive weapon.
Amongst the advantages claimed for penetration pricing include:
- Catching the competition off-guard / by surprise
- Encouraging word-of-mouth recommendation for the product because of the attractive pricing (making promotion more effective)
- It forces the business to focus on minimising unit costs right from the start (productivity and efficiency are important)
- The low price can act as a barrier to entry to other potential competitors considering a similar strategy
- Sales volumes should be high, so distribution may be easier to obtain
Penetration pricing strategies do have some drawbacks, however:
- The low initial price can create an expectation of permanently low prices amongst customers who switch. It is always harder to increase prices than to lower them
- Penetration pricing may simply attract customers who are looking for a bargain, rather than customers who will become loyal to the business and its brand (repeat business)
- The strategy is likely to result in retaliation from established competitors, who will try to maintain their market share